As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont formula -- can help us do so.
So in this series we let the DuPont do the work. Let's see what the formula can tell us about General Dynamics (NYS: GD) and a few of its peers.
The DuPont Formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:
Return on equity = net margin x asset turnover x leverage ratio
What makes each of these components important?
High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
Finally, the leverage ratio shows how much the company is relying on liabilities to create its profits.
Generally, the higher these numbers, the better. That said, too much debt can sink a company, so beware of companies with very high leverage ratios.
So what does DuPont say about these four companies?
Source: S&P Capital IQ.
Harris (NYS: HRS) has the highest returns on equity of the listed companies. While its asset turnover and leverage ratio are comparable to that offered by General Dynamics and Northrop Grumman (NYS: NOC) , it has the highest net margins of the listed companies, leading to the highest ROE. General Dynamics and Northrop Grumman have comparable net margins, (moderate) leverage ratios, and asset turnovers, and their ROEs are also fairly comparable. Textron (NYS: TXT) has the lowest returns on equity of the listed companies, with net margins far lower than the others despite boosting ROE with very high leverage -- nearly twice that of any of these peers.
Threats to cut defense budgets have hurt a lot of businesses in the defense contracting industry. Before these threats, General Dynamics, Raytheon (NYS: RTN) , and Lockheed Martin were all working to develop a prototype for a new combat vehicle. However, September of last year brought cuts to the budget for this project, which hurt all of these companies. However, General Dynamics cannot blame all of its problems on the current economic climate in the area of defense contracting, as the company was already seeing decreases in its revenue growth before rumors surfaced of budget cuts in defense.
Using the DuPont formula can often give you some insight into how a company is competing against peers and what type of strategy it's using to juice return on equity. To find more successful investments, dig deeper than the earnings headlines.
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At the time thisarticle was published Jim Royal, Ph.D., does not own shares in any company mentioned. The Motley Fool owns shares of Raytheon, General Dynamics, Textron, Lockheed Martin, and Northrop Grumman. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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